By Thibault Vasse, Senior Analyst, Sovereign Ratings

France (AA/Stable) has historically pioneered inflation-indexed sovereign bonds as the first euro area country to issue one in 1998 and has continued to issue them on a regular basis. In doing so, the French treasury has enhanced its status as a sovereign benchmark issuer responsive to rising investor demand for a hedge against inflation and lowered debt costs at issuance.

Still, with the recent rapid increase in inflation, the costs associated with these instruments has risen. Should inflation exceed expectations and persist longer-term, France could be among the euro area countries whose debt service increases the most as a direct consequence of higher inflation. The increased volatility of interest costs for inflation-linked bonds has been highlighted recently by the Cour des Comptes, the body with oversight of the use of public funds.

Inflation-linked debt amounts to around EUR 246bn, about 11.3% of outstanding debt, matched only by Italy (BBB+/Stable) among the major euro area countries. Currently, France has six bonds linked to the French consumer price index (OATi, 3.2% of the total debt stock), and twelve bonds linked to euro area inflation (OAT€i, 8.0%). It is currently contemplating the issuance of the first inflation-linked green bond in the world, reflecting its innovative debt management strategy.

Figure 1. Inflation-linked securities outstanding
EUR bn (LHS), % total debt (RHS)

Source: National debt management offices, Scope Ratings

Inflation-linked bonds can lower the cost of financing as investors are willing to pay a premium for the protection against inflation, thus lowering yields. It can also help diversify the investor base given that inflation-linked bonds may be more attractive to institutional investors with longer investment horizons such as insurers or pension funds. Even so, empirical evidence on the cost benefits of these instruments is mixed, as the premium investors pay to benefit from the hedge on inflation are typically offset by the premium sovereigns pay to compensate for the lower liquidity of the instruments.

In the current context of rising inflation, the demand for these types of instruments is rising. The issuance programme of Agence France Trésor for 2022 (as released in December 2021) expects inflation-indexed bonds to account for approximately 10% of net medium- and long-term debt issuance. In January 2022, France launched a new 30-year bond linked to euro area HICP inflation at an all-time low yield of -0.926% at issuance.

However, inflation-linked bonds can induce additional costs to issuers if there is a higher-than-expected rise in inflation. This has been the case following the price pressures due to the Covid-19 recovery, lingering supply-side bottlenecks, and the Russia-Ukraine war. The implicit interest rate on French debt increased, for the first time since 2012, from 1.14% as of end 2020 to 1.37% in 2021.

Figure 2. Implicit interest rate on French debt versus euro area inflation
%

Note: Inflation forecasts are presented as yearly averages.
Source: INSEE, Eurostat, ECB, Scope Ratings

As a mitigating factor, a short-term increase in domestic inflation may have a positive effect on the headline fiscal balance - absent an increase in discretionary spending to support purchasing power - since the nominal rise in fiscal receipts, primarily through higher VAT proceeds, could outpace that of expenditures, which are only partially indexed on inflation.

OAT€i bonds are likely to present higher fiscal costs as inflation has so far been more moderate in France than in the rest of the euro area, with 2021 HICP inflation (excluding tobacco) averaging at 2% in France versus 2.6% for the euro-area. This differential has widened in recent months, up to 1.6pps in February 2022. If this gap is sustained or even grows, there is a risk that the increase OAT€i bond payments would outpace that of fiscal revenue and further increase the total cost of public debt.

The ECB’s latest macroeconomic forecasts project euro area inflation to reach 5.1% in 2022 (up from 2.6% in 2021), while the Banque de France projects domestic inflation to reach 3.7% (up from 2.1%). Based on estimates from the Agence France Trésor, according to which every 1% rise in inflation increases the debt service by around EUR 2bn (~0.1% of GDP), inflationary pressures could drive up France’s additional cost of inflation-linked debt by around EUR 4-5bn (~0.2-0.3% of GDP) in 2022, offsetting the estimated EUR 800m gains secured in 2020 due to lower inflation. The cost of inflation-indexed bonds is expected to decline progressively in the following years, with inflation returning to below 2%, in line with the ECB’s target. However, a more adverse scenario with persistently elevated inflation could result in higher debt service costs for France over the medium-term.

Thomas Gillet, Associate Director, and Brian Marly, Associate Analyst, contributed to this commentary.